The Supreme Court in Pakistan ruled in favor of Hafiz Mohammad Saeed, the head of the charity Jamaat-ud-Dawa and also suspected a leader of Lashkar-e-Toiba, the militant group blamed for the 2008 attacks in which more than 170 people died.
A lower court ruling that Saeed must be released has been upheld on the basis that he was never formally charged and so he cannot be detained indefinitely.
Saeed was put under house arrest in December 2008 after the U.N. proscribed Lashkar-e-Toiba. He was released in June 2009 on orders of the Lahore High Court.
Pakistan's federal government and the government of Punjab province filed petitions with the Supreme Court for a review of the Lahore court's decision.
"We regard Hafiz Saeed as one of the masterminds of the Mumbai attacks and he has openly urged jihad against India," India's Foreign Secretary Nirupama Rao said.
Indian authorities have consistently said that there is evidence to show that the Mumbai attacks, or 26/11 attacks because they happened on Nov. 26, were planned and financed by Lashkar-e-Toiba based in Pakistan.
Saeed was an Islamic studies professor at the University of Engineering and Technology in Lahore and founder of Jamaat-ud-Dawa in the early 1980s. But many governments consider Jamaat-ud-Dawa a front for Lashkar-e-Toiba, designated a terrorist organization by the United States, the European Union, Australia, Pakistan, India and many other countries.
Jamaat-ud-Dawa has said it has no links with Lashkar-e-Toiba and Saeed has always proclaimed his innocence regarding the Mumbai attacks.
Pakistan's Supreme Court ruling appears to bring to an end that line of investigation regarding the deadly 26/11 attacks, which ruptured relations between India and Pakistan.
Lashkar-e-Toiba has been a vociferous opponent of what it calls Indian occupation of Kashmir, a contentious and divided border area in northwest India.
Pakistan and India have periodically gone to war over Kashmir, part of which is in Pakistan, since the subcontinent gained independence from British rule in 1947 and borders were drawn to create the two countries.
India walked out of high-level peace talks with Pakistan after the Mumbai attacks and only this month have the foreign ministers of the both countries agreed to meet face to face with a view to re-establishing a security and peace dialogue.
The meeting, decided after a previous informal meeting at a regional economic conference in Bhutan, is set for July 15 in the Pakistani capital Islamabad.
Earlier this month an Indian court began a sentencing hearing on the only surviving gunman from the Mumbai attack, Pakistani national Mohammad Ajmal Amir Qasab.
He was found guilty on 86 charges including murder, waging war on India and possessing explosives in the 60-hour attack and standoff that also killed nine other militants and injured more than 240 people.
Qasab, 22, is alleged to be a member of Lashkar-e-Toiba, translated variously as Army of the Good, Army of the Righteous and Army of the Pure.
India's home minister later said that the verdict on Qasab was a message to Pakistan not to "export terrorism to India."